Financial Markets

Unit 1

Unit 1

Financial System

Structure:
1.1 Introduction
Objectives
1.2 Constituent entities forming Financial System
1.3 Regulatory Authorities
1.4 Commercial Banks
1.5 Financial Markets
1.6 Summary
1.7 Glossary
1.8 Terminal Questions
1.9 Answers

1.1 Introduction
When you speak of Financial System we mean the set of arrangements that
cover movement of money from the savers to banks, from banks to
borrowers, and from borrowers to real assets, which in turn create savings,
which go back into the same circle.
Let us assume, you are an earning member. Out of your salary you save
10%. This finds its way to a Bank. The Bank will not just keep this. It may
give a part of this as a loan to someone who has a business. Say the
business is registered as a Company which has floated shares. Your
friends are shareholders of the company. (you are already familiar with
different forms of business and how companies are registered etc.) Now
your friends want to sell their shares. They would need a stock exchange to
sell these shares. One of your friends, who has sold the shares and
received the money, decides to visit a foreign country. He converts the
Indian Rupees into dollars through a bank which is authorized to do so. This
authorization is given by the central bank of our country which is the
Reserve Bank of India.
The set comprises entire assembly of commercial banks, financial
institutions and financial markets, each being assigned a distinct role, but all
roles complementing one another. The unified objective of the system is to
maintain liquidity in the financial market and to increase the wealth of the
country in terms of the total value of its entire goods and services.
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You can now look at figure 1.1 and visualize the interplay among savers,
Financial Sector, Real Sector and back to Savers.

Real Sector

Financial Sector

Fig. 1.1: Interplay among savers

The system commences with the funds flowing from savers, who place them
with banks and institutions as deposits to earn interest. Banks and
institutions employ these funds as loans advanced to producers of goods
and services. The producers apply these loans as resources to create
assets in the form of plant, machinery, and industrial establishments. The
revenues resulting from utilisation of these assets create savings once
again. The cycle continues endlessly in a stable economy.
Objectives:
After studying this Unit, you should be able to:

Define the Financial System

Describe the purpose of Financial System

Construct a model of the System

Briefly explain the role of each player

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1.2 Constituent entities forming Financial System

The financial system works under the overall governance of the Ministry of
Finance, Government of India. The constituent parts of the system may be
classified as:
1. The Regulatory authorities who take care of compliance of procedures
and guidelines on the part of each player in the course of its operations:
they are Reserve Bank of India (RBI), Insurance Regulatory and
Development Authority (IRDA) and Securities Exchanges Board of India
(SEBI)
2. Commercial Banks who take care of the flow of money from the savers
to the producers of goods and services in the system: They are: - Public
Sector Banks, Private Sector Banks, Foreign Banks, Regional Rural
Banks, and Co-operative Banks
3. Development Financial Institutions which take care of balanced
distribution of capital for producers of goods and services to invest in
productive assets. They are: - Industrial Finance Corporation of India
(IFCI) National Bank for Agricultural and Rural Development
(NABARD) National Housing bank (NHB) EXIM Bank
Discount and Finance house of India (DFHI) Securities
Trading
Corporation of India (STCI) State Industrial and Investment
Development Corporation (SIIDC) State Financial Corporation (SFC)
State Small Industries Development Corporation (SSIDC)
4. Non-Banking Financial Companies which provide capital to producers of
goods and services as supplementary source and help trading volumes
in capital market and money market remain buoyant. They are: Unit
Trust of India (UTI), Mutual Funds, Leasing and Hire Purchase
Companies, Loan companies, Chit funds, Insurance companies
5. Financial Markets which take care of raising public debt for meeting the
short term and long term needs of the Government, regulate the inflow
and outflow of foreign currencies in the country and help banks comply
with the liquidity and reserve norms of Reserve Bank of India as
stipulated from time to time. They are: Money Market, Foreign Exchange
Market, Capital market, Derivative Market and Debt market.

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Each of the constituent elements is briefly explained below to provide an

initial understanding. The subsequent Units will deal in extensively with
them to provide greater insight into the entire system.
The constituents of the system may be seen diagrammatically as
under:

Figure 1.2: The Constituents of the System

Self-Assessment Questions
1. The purpose of financial system is to eradicate poverty (True/False)?
2. Financial system is a means to convert savings into _________
__________________.
3. Assets formed out of investments create ____________________
Sector.
4. Trading in securities in financial markets provides _____________
___________.
5. The ratio between the value of financial assets and the value of real
assets measures ______________________.

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1.3 Regulatory Authorities

Regulatory authorities in the Indian Financial System comprise Reserve
Bank of India (RBI), Insurance Regulatory and Development Authority
(IRDA) and Securities Exchanges Board of India (SEBI). Each Regulator is
constituted under a relevant Act of Parliament and charged with the
responsibility of controlling and developing the financial institutions assigned
to it.
Reserve Bank of India
Reserve Bank of India (RBI) is the central banking institution of the country.
It was established on April 1, 1935 under the Reserve Bank of India Act,
1934 which vested in it the role of regulating the financial system of the
country. Although it was a privately owned body during the British rule, since
its nationalization in 1949 the Bank is fully owned by the Government of
India. The RBI is the Banker of all banks in India.
The roles of the Bank as a regulator comprise:
Issuing currency notes and coins
Managing Balance of Payment position
Regulating money supply in the economy
Managing the external value of Indian Rupee
Raising resources for the Government
Regulating and supervising the operations of commercial banks and
Institutions
Banking Ombudsman Scheme
Evolving monetary and credit policies at periodic intervals
Issuing currency notes and coins
The Bank is the custodian of currency notes and coins that are in circulation
at any point of time. It decides the volume of currency and coins to be
circulated in the system. It is the sole authority to print the notes at the
Government press and manufacture coins in Government mints in specified
denominations from time to time. You can see the signature of the RBI
governor in the currency notes.
Managing Balance of Payment position
Balance of Payment (BOP) refers to Indias external obligations The Bank
regulates foreign trade in order to be able to discharge foreign debt without
default. In case the BOP shows large debts or borrowings and shows high
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imports as against exports, the RBI could restrict imports and also take
measures to correct the imbalance to some extent.
Regulating money supply in the economy
Volume of money in the economy at a given time determines to an extent,
the rate of inflation in the country. In simple terms if larger supply of money
chases lesser supply of goods and services, it could lead to inflation. As
regulator of countrys overall economy, RBI controls the volume of money
supply by asking banks to withhold a percentage of their deposits from
lending. The ratio between the cash to be withheld as against the deposit
with the bank is called Cash Reserve Ratio (CRR). RBI modifies CRR
according as the volume of money appears too large or too small.
Managing the external value of Indian Rupee
RBI closely regulates the supply and demand positions of foreign exchange
in the market by suitably controlling imports and exports. The Bank may also
directly enter the forex market by either buying up or selling foreign currency
to rebalance supply and demand; the Bank thereby keeps the rate of
exchange between the Rupee and foreign currency in check.
Raising resources for the Government
As custodian of Government money, RBI raises funds from the public on
behalf of the Government either for short term or for long term. The short
term loans are intended to meet the temporary mismatches in cash flows,
that is, timing difference between revenue receipts (taxes) and revenue
payments (salaries, rent, and recurring costs, called non-plan expenditure).
RBI may raise such loans by way of selling Treasury Bills of short duration
up to 364 days to banks, corporates or other investors, or by itself providing
short term accommodation termed Ways and Means Advances to the
Government.
RBI may issue long term bonds to finance Government projects under the 5year plans. These are called dated securities and would have maturities
longer than one year. Banks, Institutions, Mutual Funds, Insurance
Companies, Corporates and Foreign institutional investors are the players to
whom the RBI sells the bonds through auctions.

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Regulating and supervising the operations of commercial banks and

Institutions
Scope of regulation, supervision and guidelines of RBI over commercial
banks extend to the following areas:

Compliance of Cash Reserve Ratio and Statutory Liquidity Ratio

requirements

Interest rates charged on certain types of advances

Compliance with Managing Non-performing Assets and Capital

Adequacy norms
Banks are required to identify loans and advances where borrowers
have defaulted in payment of either interest or instalment or both.
These are to be reported as Non-performing Assets. Each bank is
required to make a provision for the expected loss arising out of
them before reporting profits. Appointment of Directors on the Board
RBI supervises banks compliance with Corporate Governance
norms. Thenorms extend to Composition of Board of directors, Code
of Conduct of Directors, the performance of Audit Committee,
conduct of Annual Meetings of shareholders, and other areas of
concern for good governance of the bank.

Compliance of Know Your Customer

Banks are required not to open accounts for strangers or undesirable
persons.

Quality and security of loans

Quality of appraisal, determination of loan amount, obtaining of
adequate and marketable security, and documents from the
borrower are subjected to periodic inspection of each branch of the
bank by RBI.

Rectification of irregularities reported by Inspectors

RBI scrutinizes the reports of statutory auditors and its own
inspectors on the branches of the banks to see whether irregularities
mentioned therein are rectified.

Banking Ombudsman Scheme

Banking ombudsman (BO) is a quasi-judicial authority created by RBI to
resolve complaints of bank customers relating to certain services rendered
by banks. The Scheme provides for (i) an expeditious and(ii) inexpensive
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forum to bank customers to seek redressal of their grievances relating to

certain services rendered by the Banks.
Evolving monetary and credit policies at periodic intervals
RBI announces its Monetary Policy every year and a half-yearly review of it,
if needed. The policy scans the economic situation and proposes the steps
that the Bank would adopt to strengthen the economy and its sustainable
growth. Broadly, the steps would aim at achieving a self-imposed target for
rates of industrial growth and growth in Gross Domestic Product.
As a corollary to its monetary policy, RBI enunciates its Credit Policy
periodically. Credit policy primarily covers review of CRR and SLR, RBIs
interest rate for lending and borrowing to and from commercial banks,
restrictions or relaxation for banks in lending to traders for procuring and
holding essential commodities, regulating or deregulating interest rates
charged by banks on their lending or the rates they may offer to depositors.
Self-Assessment Questions
6. Balance of Payment statement is drawn up by Ministry of Finance,
Government of India (True/False)
7. Money supply in the economy is regulated by
(a) Ministry of finance
(b) Ministry of Revenue
(c) Reserve Bank of India
(d) Commercial Banks
8. Cash Reserve Ratio is a tool to regulate money supply in the economy
(True/False)
9. Loan to Deposit ratio measures _________ of a bank
10. Ways and Means Advance is money loaned by RBI to the
Government to help meet___________
11. Capital Adequacy Ratio of banks helps RBI regulates their profitability
(True/False)
Insurance Regulatory Development Authority of India
Insurance Regulatory Development Authority of India (IRDA) was
constituted under the IRDA Act, 1999. It is the regulator of all insurance
companies both in public and private sectors. Companies that offer any
insurance product life insurance, general insurance or medical insurance
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are governed by IRDA. Besides administering the provisions of the Act, the
objective of IRDA is to ensure that insurance companies do not default in
meeting genuine claim settlements of the persons insured or their
successors.
With this objective, the Act requires that every insurance company should
maintain a deposit with RBI a stipulated percentage of its total gross
premium written in India in any financial year. Besides, every insurer should
maintain a minimum paid up share capital of Rs.100 crores; the promoters
quote not exceeding 26 per cent thereof.
Securities Exchanges Board of India
Securities Exchanges Board of India (SEBI) was established by the
Government under an Act of Parliament, the SEBI ACT, 1992. The Board is
charged with the duty to protect the interests of the investors in securities
and to regulate, maintain and develop the securities market operations.
As a regulator, the Board is required to perform the following
functions:
Regulate the transactions that take place in the stock exchanges
Admit and Register stock brokers and regulate their working
Regulate the working of sub-brokers, share transfer agents, bankers to a
public issue, Debenture trustees, registrars, merchant bankers,
underwriters, portfolio managers, and any other intermediary associated
with a public issue of shares or debentures
Registering and regulating the working of depositories and depository
participants
Regulate all public issues of shares and debentures by companies in
terms of the size of the issue and the purpose of issue, by vetting the
companys application made to it, the advertisement placed in the
newspapers and the offer letter addressed to the public
Promoting investors education and training of intermediaries
Conduct of inspection and dealing with fraudulent or unfair trade
practices
The Board conducts inspection of stock exchanges and mutual funds
regularly to ensure compliance of its regulation and guidelines. Also, the
Board has the same powers as are vested in a civil court while trying a legal
suit. It has accordingly the powers to call for any information from the
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exchanges or banks or companies while conducting an investigation into

any complaint or allegation. The Board has the power also to inspect and
investigate the brokers, sub-brokers and other intermediaries on a complaint
by an investor.
The Board is empowered to take any measure that it thinks right in the
interest of the investors. Such measures may include suspend trading in any
security in any exchange, order delisting of shares of the errant company,
suspend brokers and intermediaries from trading, suspend and file a legal
suit against any office bearer of an exchange, and impound and retain the
proceeds of a trade which is under investigation by it.

1.4 Commercial Banks

Commercial banks are banking companies registered under Banking
Regulation Act, 1949 and categorized as Schedule Banks and nonSchedule banks. Schedule banks are those that are listed in Schedule VI of
the said Act. Banks are further distinguished based on their ownership.
Accordingly, they are either (i) Public sector banks or (ii) private sector
banks. Public sector banks are those in which the Government is a major
shareholder, while no shares are held by the Government in Private sector
banks. Among Private sector banks, are also included foreign banks
operating in India.
A sub-category among commercial banks is Authorised Dealers (ADs). Only
those commercial banks can conduct foreign exchange business, which
have been designated as Authorised dealers (AD) by RBI. RBI grants AD
status to a bank based on, among other things, the banks capital adequacy
measured by Capital to Risk Adjusted Asset Ratio, Risk management policy
being in place and availability of qualified staff.
Classification of Commercial Banks is shown in figure 1.3

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Fig. 1.3: Classification of commercial banks

Public sector banks

Public sector banks are distinguished as State Bank Group and Nationalised
banks. State Bank Group comprises State Bank of India and its subsidiaries,
namely,
State Bank of Mysore
State Bank of Hyderabad
State Bank of Travancore
State Bank of Indore and
State Bank of Patiala.
The subsidiaries were the erstwhile banks of the princely states and were
established as State Banks carrying the names of the respective states
when the princes of those states were divested of their status after
independence.
Nationalized banks were private banks which were taken over by the
Government in two stages after 1968 by an Act of parliament. Currently,
they are 28 in number.

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Private sector banks

Private sector banks are privately owned. Banks that came into existence
following economic liberalisation and market reforms in 1992 are referred as
new private sector banks. Some of them are, ICICI Bank, HDFC Bank, UTI
Bank, Kotak Mahindra Bank, and Yes Bank. Their shares are listed in the
exchange and are widely traded. Currently, there are 24 banks in private
sector.
Foreign banks
Over a long time, foreign banks have been operating in India. Historically,
their presence was in port cities of Kolkata, Mumbai, and Chennai, as their
main business was financing imports and exports. Citibank, HSBC bank and
Standard Chartered Bank are currently the majors operating in India.
Foreign banks function mainly in metropolitan centres and are not into mass
banking or retail lending. They focus on services, such as, issuing letter of
credit and guarantees which do not imply fund outlay. These banks do
contribute, however, to the Indian banking, as they bring in new products
and technology, introducing an element of competitiveness for domestic
banks.
Foreign banks are also regulated by RBI and are subject to CRR and SLR
compliances with regard to their Indian operations.
Regional Rural Banks
With a view to extend financial inclusiveness of the rural population,
Regional Rural Banks (RRBs) were set up by the Government of India
under an Act of Parliament. These banks have a blend of a cooperative
society and a commercial bank, as their objective is not profit while doing
banking business. Each RRB is sponsored by a nationalised bank or a State
Bank group member in an area specified to it. The capital of RRB is
contributed by the Central Government, the Government of the state in
which it functions, and the sponsor bank in the proportion of 50:15:35. RBI
regulates RRBs, while NABARD supervises its operations, as their lending
operations are mainly for agriculture.
Cooperative Banks
Cooperative Banks (CBs) are set up under the Cooperative Societies Act
prevailing in the State in which it operates. CBs can accept deposits from
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the public at large but can lend only to their members holding their shares.
Some CBs are permitted to operate in States other than where they are
registered. Non-schedule CBs cannot participate in clearing house except
through a designated commercial bank, while schedule CBs can be
members of the clearing house.
CBs can conduct foreign exchange business, if granted the status of
Authorised Dealer by RBI.
CBs may be registered as State cooperative banks or District or Urban
cooperative banks, the latter operating mainly within a specified district of
the State. All CBs are regulated by RBI and subject to CRR and SLR
compliance although RBI may stipulate diluted ratios for them. CBs are
supervised by the Registrar of Cooperative Societies of the State.
Development Financial Institutions
Development Financial Institutions (DFIs) are term lending institutions set up
under respective Acts of Parliament for the purpose of developing specific
sectors of industry. They are established both at national level and in the
States. With the difference in the functioning of commercial banks and DFIs
virtually disappearing, we have now only IFCI as a DFI at the centre doing
direct lending. State DFIs however continue to operate alongside
commercial banks. RBI is the regulator of DFIs.
Non-banking Finance Companies
Non-banking Finance Companies (NBFCs) are those which provide services
of financial nature but are not registered as commercial banks. They do not
conduct banking business, such as, opening current and saving accounts,
collecting cheques, issuing drafts and similar. However, they may accept
public deposits under various schemes of their own. The services offered by
them include Equipment leasing, Hire-purchase financing, mutual funds,
Chit funds, among others. NBFCs are required to be registered with RBI,
which is also their regulator.
Among NBFCs may be grouped Insurance Companies and Mutual
Funds. Insurance companies are classified as Life insurers (Life insurance
Corporation of India, SBI Life, ICICI Prudential are leaders in this sector)
and General insurers (National Insurance Corporation Ltd., United India
Insurance Corporation Ltd., and ICICI Lombard Ltd., are the leaders). All
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insurance companies are regulated

Development Authority (IRDA).

Unit 1

by Insurance

Regulatory and

A Mutual Fund is established as a Public Trust which has (i) a sponsor

(ii) trustees (iii) an Asset Management Company (AMC) and a (iv) a
Custodian. Sponsor is the promoter who establishes the trust. The trustees
hold the trust property for the benefit of the general public who subscribe to
the fund by way of units. AMC manages the funds of the unit holders by
investing their money in securities and trading in them on their behalf to
raise maximum gain. AMC formulates various investment schemes to best
advantage. The Custodian holds the securities of the fund in its custody.
Units earn dividends for the holders who may not have been able to
construct and manage their own portfolio, owing to lack of expertise and the
smallness of size of investment. The holders may also sell back their units
to the fund at the net asset value ruling from time to time.Net asset value is
the market value of the securities held by the fund at a given point in time
less liabilities, divided by the number of outstanding units. SEBI is the
regulator of mutual funds, regardless of the nature of the securities in which
they invest.
Self-Assessment Questions
12. Regional Rural Banks are regulated by RBI (True/False)
13. State Cooperative banks are regulated by respective State
Government, while urban cooperative banks are regulated by RBI
(True/False)
14. Mutual funds investing in Treasury Bills are regulated by RBI as they
are money market instruments (True/False)
15. Trading in securities for mutual funds is the function of
(a) Sponsor
(b) Custodian
(c) Asset Management Company
(d) Trustees

1.5 Financial markets

A financial market is not a physical place as one where you buy and sell a
commodity, but a virtual medium for transferring ownership or claim over
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securities between two parties. Trading in money, shares, bonds or

contracts are done at prices chosen between a buyer and a seller under the
supervision of an intermediary called Exchange. The role of the exchange is
to ensure that the seller delivers security and the buyer makes the payment
at settlement, without default.
The classification of Financial Markets is shown in figure 1.4

Fig. 1.4: Classifications of Financial Markets

Money market
Money market is the medium through which (i) money is borrowed and lent
and (ii) short duration debt instruments are traded. The main players are
banks, insurance companies, provident funds, and mutual funds. Banks
borrow from money market when they need money for complying with SLR
and CRR requirements. Insurance companies, mutual funds and others can
only lend money and are not permitted to borrow. Their duration of such
borrowing can vary from one day to 364 days. Money borrowed for one day
is called Overnight money, upto two days is called Call Money, and upto
14 days is called Notice Money. Money borrowed for periods ranging from
15 days to 364 days is called Term Money. Interest rates are market driven
and not administered.

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The second constituent of money market is trading in Debt Instruments.

They comprise promissory notes of maximum maturities of one year which
generate short term funds for the issuer. The instruments are:
Treasury Bills issued by RBI on behalf of government
Commercial Paper issued by corporates and
Certificates of Deposit issued by banks and financial institutions.
These instruments are issued at a price lower than the face value, and carry
no interest for the period. They are called Zero coupon bonds, the difference
between the face value and the discounted price becoming the return for the
buyer.
RBI is the regulator of money market. It does not directly administer the
interest rates in the market, but effectively intervenes when interest rates
appear to move widely from a stable position. Intervention implies that RBI
infuses money into the market by lending large amounts when interest rates
appear high and sucks out money when interest rates appear to be sinking
low. This activity is called Open Market Operation of RBI.
Capital Market
This is the medium available for corporates for raising long term funds
through issuing shares and bonds to the public. Investments raised by
public issue forms the primary market leg of the capital market. After
allotment of shares and bonds, they are listed on the stock exchange.
Listing means that those shares and bonds can be traded through the
members (brokers) of the exchange.
Trading in shares and bonds so listed forms the secondary market leg of the
capital market. Buyers and sellers of these securities operate through their
respective brokers. The exchange acts as a clearing house and ensures
that the buyers duly make the payment and that sellers duly deliver the
securities on the settlement date.
Derivative Market
A second constituent of capital markets is the Derivative Market. A
Derivative is a financial instrument whose value springs from the market
price of an asset that lies under it. The underlying asset may be a share, a
bond, a foreign currency, a commodity, or even a virtual asset such as a
sensitivity index of an exchange.
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Derivative instruments are tradable over the Exchange. Typically,

derivatives are:
Swaps which are contracts between two parties exchanging interest
rates or currencies
Option which is a contract with option retained by one party to buy or sell
an asset on a future date at an predetermined price
Futures, which is a standardised forward contract to buy or sell an asset
on a future date at a predetermined price
Warrant, which is an instrument attached to a bond representing a
stated number of shares of the issuing company
The regulator of both capital and derivative markets is SEBI.
Debt Market
Debt market is the medium through which RBI can arrange funds for
Government projects by raising long term loans from the public. RBI issues
bonds (also called debentures) referred as Gilt securities or G-secs or Dated
Securities. They are tradable in the secondary market. Debt market is
regulated by RBI.
In the primary market, the Government issues bonds by holding auctions on
dates previously announced. The bidders at the auctions could be banks,
institutions, insurance companies, provident funds, corporates or Primary
Dealers (PDs). PDs are intermediaries who buy securities in large
quantities at auctions and sell them in retail to individual investors.
In addition to Treasury Bills and Dated Securities, the government also
issues from time to time special securities to entities like Oil marketing
companies, Fertiliser companies, The food Corporation of India, and others,
as compensation in lieu of cash subsidies.
Government securities are traded heavily in the secondary market since like
any other financial instrument, the price of a government security keeps
fluctuating in the secondary market. Their prices are influenced by the
changes in interest rates in the economy, specifically in money market,
besides macro-economic changes, such as, expected inflation rate and
liquidity in the market.

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Foreign Exchange Market

If there was a single international currency, there would be no need for a
foreign exchange market (Forex market). That being not so, in any
international transaction, at least one party is dealing in a foreign currency.
The purpose of the foreign exchange market is to permit transfers of
purchasing power denominated in one currency to another, that is, to
exchange one currency for another.
More currency transactions are channeled through the worldwide interbank
market the wholesale market in which major banks exchange different
currencies of the world with one another. This market is referred as the
foreign exchange market. The market is not located in any single country
but is dispersed over the major financial centres of the world. Trading is
generally done through telephone or on electronic trading platforms.
The major traders in forex are the banks, although large corporates may
also play. Exchange of currencies implies buying and selling of one currency
for the equivalent price of another currency.
A major reason for the banks to trade in forex markets is their need to sell
away excess currencies that they may be holding at the end of each day in
order to avoid overnight fall in their market price. For similar reason, banks
buy up currencies if they had sold more currency than they had bought
during the day in order to avoid a rise in market price overnight. Banks are
thus required to buy or sell currencies each day to square up their currency
balances to make them come as near to zero as possible.
As banks trade currencies wholesale among themselves, forex market is
also called interbank market, or simply, the Interbank. Exchange rate
between each pair of currencies evolves by sheer forces of demand and
supply of those currencies on a daily basis. Interbank quotations are
available continuously as bid and ask rates, meaning market is willing to buy
currency at one rate and sell currency at another rate. The rates are quoted
together and are therefore called two-way quotes. Obviously, markets bid
rate is always lower than markets asking rate. Bid/Ask rates are available
as Spot and Forward. Spot rate stands valid for settlement on the third
working day after the transaction day and Forward rate is fixed for applying
on a future date as agreed in a contract made between the trader and the
bank.
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Forex market does not have an exchange, as each transaction is done

directly between the traders over the counter. Also, there is no statutory
regulator, but RBI may intervene as a big player to influence the exchange
rates.
Self-Assessment Questions
16. Mention three instruments that are traded in money market
17. When RBI desires to reduce money supply does it make a Repo or a
Reverse Repo?
18. In money market, Notice money is money borrowed for
(a) One day
(b) 15 days
(c) Period from 15 days to 365 days
(d) Period from 3 days to 14 days
19. Open Market operation means
(a) Traders permitted to transact freely
(b) RBI directly entering the market to stabilize it
(c) Trading by foreign entities
(d) None of the above
20. Secondary Market is a stand-by market when primary market in
operable (True/False)
21. Depository is a trustee who sells securities of traders at fair prices
(True/False)
22. Instruments that are traded in derivative market are.......
23. Debt market is regulated by
24. Primary Dealer is a trader who buys securities in bulk and sell them in
retail (True/False)
25. Primary reason for banks to trade in Forex market is
26. Regulator of Forex market is
(a) RBI
(b) Government of India
(c) SEBI
(d) No one

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1.6 Summary
Financial System is the set of banks, financial institutions and financial
markets, each playing a distinct role, all roles complementing one another.
The unified objective of the system is to maintain and develop the health of
the countrys economy.
The constituents of the financial system convert savings into investible
funds. Banks mobilise money from the savers and lend to producers of
goods and services. Producers generate assets which contribute to the
national capital, also termed Gross Domestic product.
Banks are classified as commercial banks and cooperative banks.
Commercial banks are registered under Banking Regulation Act, while
Cooperative banks are registered under the respective Cooperative
societies Act. Commercial banks are permitted to do all banking operations,
while commercial banks are restricted in their operations. Both categories
further fall into two parts schedule banks and non-schedule banks,
depending on their net worth and size of business.
Commercial banks are classified as public sector banks and private sector
banks depending on their pattern of their ownership. Some commercial
banks are required to be sponsors of Regional Rural Banks which are
established to operate in rural parts to promote financial inclusiveness.
All banks are regulated by Reserve Bank of India. As regulator, RBI controls
the volume of money supply in the economy through regulating the extent of
bank lending. RBI also supervises the liquidity of banks for economic health
of the country.
Financial markets comprise (i) money market where banks and institutions
lend and borrow wholesale, (ii) capital market where corporates issue
shares and bonds and investors trade in them and (iii) debt market where
the Government borrows from banks and institutions by floating long dated
bonds and (iii) forex market where banks buy and sell different currencies of
the world to facilitate imports and exports.
All markets are inter-dependent as the volume of trade in one market
distantly or proximately impacts on others.

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1.7 Glossary
Financial Asset: Money invested in securities and deposited in banks
Balance of Trade: Excess or deficit between imports and exports
Cash Reserve Ratio: The specified percentage of its time and demand
deposits that a bank is required to keep with RBI
Call money: Money borrowed by a bank in money market upto 2 days
Open market operation: The process of RBI entering a market as a
trader in his own right
Gilt securities: Bonds issued by RBI on behalf of Government
Treasury bill: Short term paper floated in money market to bridge
temporary mismatches of cash flow of the Government
Credit policy: Program of RBI relating to bank lending enunciated
periodically to regulate economy
Bid/Ask quotes: Rates at which a bank is willing to buy/sell foreign
currency
Interbank: Market comprising banks willing to trade in foreign currency
among themselves
Forward contract: A contract between a bank and customer locking
exchange rate of a currency for settlement on an agreed future date

1.8 Terminal Questions

1. Financial System is a set of arrangements that cover borrowing and
lending of funds and transfer of ownership of financial claims. Explain
the implications by outlining the role of each constituent in the system.
2. Distinguish the functioning of Capital market and Debt market.
3. Outline the features offered by Forex market. Why does RBI intervene
becoming a major trader?

1.9 Answers
Self-Assessment Questions
1. False
2. Investments
3. Real
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4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.

Liquidity
Contribution of financial system to national capital
False
Reserve Bank of India
True
Liquidity
Temporary mismatch of cash flows
False
True
False
False
(c)
TB, CP and CD
Reverse Repo
(d)
(b)
False
False
Swaps, Options, Futures, Warrants
RBI
True
To off load their closing stock of foreign currency to avoid exchange
risk
26. (d)
Terminal Questions
1. Refer section 1.2
2. Refer sections 1.4.2 and 1.4.4
3. Refer section 1.4.5
Recommended reading
1. Indian Financial System, Bharathi Pathak (2011) (Thompson)
2. Financial Institutions and Markets, L.M. Bhole (2010) Tata Mcraw-Hill

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